Non-Traded REITs Face More Scrutiny from Broker-Dealers

Broker-dealers are increasingly being selective about the non-traded REITs they include on their investment platforms today, and they’re subjecting those investments to greater scrutiny.

“There are more non-traded REITs today than there has ever been, and as a broker-dealer, you have to make tougher choices,” says Steph M. Laflamme, managing director of the financial services group for First Allied Securities Inc. He notes that most broker-dealers have reduced the number of non-traded REITs on their platform to allow for greater oversight and to mitigate sector duplication.

“We want to offer a robust set of options, but at the same time we want to make sure we’re focusing on the best sponsors and the best investments,” Laflamme adds. “We can be very choosy.”

At First Allied Securities, the due diligence process has expanded to include a robust checklist of items, as well as a multi-person investment committee rather than a handful of decision makers, Laflamme says. “It’s not as relationship-driven as it was years ago,” he notes. “The decisions are more a matter of the merits of the sponsor and the REIT’s ability to satisfy advisors and investors. We certainly don’t let relationships drive the decision.”

Ongoing due diligence

Industry experts contend that there isn’t one overarching reason why broker-dealers have changed the way they approach non-traded REITs. “There were a series of things that occurred to put pressure on the firms and force them to rethink the way they review these programs,” says Keith Allaire, managing director with Robert A. Stanger & Co., a Shrewsbury, N.J.-based investment banking firm that focuses on real estate.

The entire non-traded REIT industry has experienced heightened attention from regulators. Moreover, recent litigation has specifically called out both non-traded REITs and their broker-dealers. The biggest wakeup call, however, was the resetting of commercial real estate values.

“As a result of the market downturn, broker-dealers have become more careful about the products they’re putting up,” Allaire says. “There has been a greater focus on the quality of the investments. That’s not to say there wasn’t a substantial focus before, but it’s definitely increased. The bar is set much higher.”

Michael Schwartz, CEO of Strategic Self Storage Trust Inc., a non-traded REIT that specializes in self-storage assets, says he’s definitely noticed a difference in the way broker-dealer approach the due diligence process. While a certain level of analysis and scrutiny was expected when a broker-dealer was considering the addition of a new non-traded REIT to its platform, the amount of ongoing due diligence was limited.

“Ten years ago, broker dealers would maybe do a refresher every year,” Schwartz says. “Today, most firms are mandating quarterly monitoring through outside due diligence firms. And some will even give you a call or drop by to go over those results.”

Schwartz is quick to say that he’s not complaining about the more frequent due diligence. “The additional level of scrutiny is a positive thing for the space,” he says. In fact, he likens the process to weight lifting. “Every time we go through the due diligence process, we get stronger because it substantiates that we’re doing exactly what we’re obligated to do.”

Difficult for new non-traded REITs

Broker-dealers’ increased scrutiny and leaner investment platforms mean that new sponsors and new non-traded REITs are finding it difficult to enter the market, experts note.

“In a rising market, it was a lot easier for a non-traded REIT to get on a broker-dealer platform,” Allaire notes, adding that many programs are left out in the cold. “Today, if you’re a new sponsor, it’s chilly. And it’s not very warm for those who’ve lost their place on a platform either.”

Indeed, if a broker-dealer is satisfied with the non-traded REITs it has on its platform—if it feels comfortable with the sponsors and the REITs cover a broad spectrum of property types—those REITs are likely going to maintain their position, leaving no room for new entrants, Schwartz points out.

Yet industry experts contend that broker-dealers’ decision to pare their non-traded REIT offerings translates into better oversight and less risk for investors, despite the fact that it also means that investors have fewer choices.“As an investor, wouldn’t you rather have access to five quality investments rather than 10 mediocre investments?” queries one broker-dealer executive.